Earnings on Tap
The broader market averages saw one of their best weeks in years last week only to give back most of those gains in the first two trading days this week. As I noted in the most recent issue of The Energy Strategist, Strengthening Headwinds, I believe we have more downside and volatility to come near term as the averages continue to price in a growing risk of recession. Economic indicators continue to suggest that a US recession is likely.
Ultimately, the energy boom is driven by strong demand overseas and a continued tight supply environment. This bullish picture hasn’t changed. However, energy stocks are still stocks and are therefore not immune to broader market volatility.
But we can still make money in this environment. Some stocks, including a handful of names leveraged to a recovery in natural gas, should perform well. For the first time since early 2006, there are signs of stabilization in this market.
And not all energy-related firms are seeing the same trends. Careful stock selection has been the key to outperformance over the past few years, and that will likely remain the case in 2008.
And we’ll also examine the offshore drilling business and why I believe it’s an excellent time to make a few plays on a turn in the Gulf of Mexico shallow-water drilling business.
Because the world’s large onshore fields are now mature, producers are increasingly targeting more complex fields in harsh environments such as the Arctic and deepwater. The complexity of these fields requires new tactics—and new deals. See Oil and Gas Services.
Although other oil and gas services may be experiencing some stalled growth, Weatherford International is still moving steadily, thanks to expansion into new markets. The company leads several high-demand sectors in technology and service. See Weathering the Storm.
I’ve recommended several put options in the past couple months, one of which is worth reviewing. There are also a couple oil service plays that I thought should be addressed. See Putting It to the Test.
I hold several contract drillers in the portfolios that serve as pure plays on this industry. Some will be stronger than others in the upcoming year. I review them here. See Contract Drillers.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
And within the services sector, the key has been to focus your portfolio on services companies levered to growth offshore and outside of North America. International powerhouses Schlumberger and Weatherford International, for example, have outperformed the broader oil services index by roughly 30 percent over the past three years.
The main reason for this growth relates back to one of the core themes of this newsletter: the end of easy oil. (I highlighted this theme and what it means for the services group at length in the Jan. 2 issue of TES, Taking Stock of 2007.)
Because the world’s large onshore fields are now mature, producers are increasingly targeting more complex fields in harsh environments such as the Arctic and deepwater. Onshore, producers are going after smaller pockets of oil; to produce these fields requires the use of the most-advanced well designs and oilfield technologies. These trends all play right into the hands of the world’s oil services firms.
Another factor aiding the services firms is petro-nationalism. Traditionally, the state-owned or partly state-owned national oil companies (NOC) have preferred to partner with major integrated oil firms on exploration and development projects. The majors, including companies such as Total, ExxonMobil and Chevron Corp, have the experience, technology and project management skills required to handle complex projects.
In exchange for providing these services, the NOC would typically offer the integrated majors a share in the production of their projects. In many cases, the NOCs were even willing to cede overall control of key projects to the majors.
That’s no longer the case. In recent years, NOCs and foreign governments have started to exert more influence over major oil projects; in some cases, this has involved actually changing the terms of partnership deals with the integrated majors.
For example, Kazakhstan recently renegotiated the terms of its partnership with foreign integrated oil companies to develop the giant Kashagan field in the Caspian Sea. The consortium of foreign oil giants developing the field–including Eni, ExxonMobil and Royal Dutch Shell–agreed to pay Kazakhstan $2.5 billion to $4.5 billion in compensation for the late start of the project. In addition, Kazakhstan’s NOC is doubling its stake in the deal.
We’re also seeing the big NOCs partner with major oil services firms such as Schlumberger on development deals rather than oil majors. Rather than partner with an integrated firm and be forced to give up a stake in the field, the NOCs simply pay the services firms to manage the project on their behalf. This business line is known as integrated project management (IPM).
The NOC will normally contract with a services firm to manage all aspects of a project. That may include arranging drilling rigs, ordering equipment or contracting with other services firms for certain aspects of the job.
The key point is that the NOCs can get access to the most advanced oilfield technologies without having to give up a share or cede control in their fields to a major foreign oil company. IPM is one of the hottest, fastest-growing business lines for the major service firms. Petro-nationalism is another key growth driver.
This basic bullish case for the services firms remains intact longer term. However, based on recent results and conference calls, I think the bull case for the services firms is on hold for the next quarter or so, thanks to what’s come to be known as the platform problem. Although stocks such as Schlumberger are well supported on a valuation basis, I just don’t see a great deal of near-term upside.
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I mentioned the platform problem in the most recent issue of TES with reference to Schlumberger. The basic problem is that demand for offshore oil and gas exploration and development remains strong, but there just aren’t enough drilling rigs out there to handle all of the projects. Producers would like to drill more aggressively but can’t get access to the rigs.
To make matters worse, when a new drilling rig is first launched, it takes time for that rig to reach peak efficiency; brand new rigs aren’t as efficient as rigs that have been in service for a few years. Therefore, services firms such as Schlumberger have stated that they see their international growth constrained by the lack of rig platforms available to pursue projects.
This isn’t a new phenomenon. As I highlighted in the most recent issue of TES, Schlumberger offered an early warning of the platform problem in its third quarter conference call last year. However, it does appear that the problem is more acute than many had assumed.
This is clear from Baker Hughes‘ earnings report released last week. Baker stated that deepwater activity will remain constrained this year because of lack of rig availability.
The company also noted that some of its highest-margin services are those that pertain to deepwater work. The platform problem will have an outsized effect on profitability by hitting hardest Baker’s most profitable service lines. The company went on to describe 2008 as a transitional year for the services industry because of this issue.
Another worrying trend to emerge from Baker’s call was the idea of heightened competition among the big services firms for high-profile projects. Baker’s CEO Chad Deaton stated that he’s starting to see some aggressiveness on the big contracts out there.
The major oil services firms are competing for these deals partly on price. Deaton was careful to say that pricing power is holding up well internationally.
But this raises the possibility that, because of the platform issue, services firms are having trouble finding growth offshore. That means they’re competing aggressively on a handful of big international deals. If that’s the case, it could mean there’s more pricing pressure to come on the international front.
I suspect we’ll see this platform issue gradually fade after midyear. The reason is simply that a host of new offshore rigs are finally coming out of shipyards and going into service. Check out the chart below for a closer look.
Source: Offshore Magazine 2007 Worldwide MODU Construction/Upgrade Survey
The chart shows scheduled deliveries of newbuild floater rigs over the next few years. Floater rigs are literally rigs that are designed to float on the water rather than be supported by pilings that touch the bottom of the sea. They’re typically used for drilling in deeper waters.
To construct the chart, I included both newly built rigs and those undergoing major renovations. I further divided each bar in the chart between total floaters scheduled for delivery and ultra-deepwater rigs. The ultra-deepwater rigs are rigs capable of drilling in water of more than 7,500 feet in depth. These would represent the most advanced deepwater rigs.
It’s clear from the charts that, during the next year, a wave of newbuild floater rigs are scheduled for delivery. Many of these rigs are capable of drilling in the deepest waters.
The essence of the platform problem is that there aren’t enough deepwater rigs to meet demand; as these rigs are delivered, that problem will gradually ease. But this process will take time.
Based on what I’m hearing from companies like Schlumberger and Baker Hughes, I’m looking for the services firms to enter a soft patch over the next six months or so. These companies will see their international growth constrained by lack of rig availability (the platform problem), while the few big contracts that do come up will be aggressively bid.
That means there’s risk they could be forced to cut prices to win business. This certainly won’t destroy growth prospects, but it will be enough to temper their pricing power and near-term growth prospects.
This brings me to Weatherford. I must confess a degree of incredulity arising from my initial consideration of the company’s results and management’s conference call; Weatherford, Schlumberger and Baker Hughes are all in the same basic business and have the same overall customer base.
It would seem ridiculous to believe that Weatherford could somehow thrive while all its competitors are trying to talk down analysts’ earnings estimates and warning about platform issues. Yet Weatherford says it’s looking for growth rates of close to 40 percent over the next two years in its international markets, while Schlumberger is looking for growth at basically half that level.
Apparently, I wasn’t the only one who had that thought. Weatherford’s management team was grilled during the question-and-answer session following the conference call by several analysts from different firms. The basic question: “How can Weatherford’s international growth remain so strong while competitors are struggling with the platform problem?”
A couple logical reasons for Weatherford’s outperformance emerged from this discussion. First and foremost, Weatherford is starting from a much smaller base on many of its key product lines. The company has some highly competitive, relatively new technologies that aren’t yet widely marketed and deployed in all oil- and gas-producing countries of the world.
As Weatherford rolls out these high-tech services into new international markets, it’s able to generate growth quickly. In other words, there are still plenty of markets where Weatherford doesn’t yet have a major presence. As the company targets these new markets, it’s able to grow far faster than the industry average.
In response to an analyst query, the company’s CFO Andrew Becnel stated:
Weatherford has room to grow by simply taking proven, existing technologies and selling them into new markets. This differs from a company such as Schlumberger, which has already saturated many of its key markets and, therefore, has less room to expand from the same process.
A perfect example is Russia, a market where Weatherford had almost no exposure just a few years ago. (I highlighted the attractiveness of the Russian market at length in the Dec. 19, 2007, issue of TES, Focus on Russia.) Weatherford aggressively targeted this market to boost its presence.
Although the company did make a few small acquisitions, most of the growth was organic; Weatherford simply sold its existing services into this new market. Now the company has more than 2,500 employees in Russia.
I also see Weatherford entering the sweet spot of its growth cycle right now. Consider that just three years ago, Weatherford had far greater exposure to the North American market; its international operations were still relatively small.
As Weatherford began to expand internationally, it hired new employees in global markets and spent considerable sums building its presence. With the base of international revenues still small, these startup costs were high relative to international revenues.
But that investment is beginning to pay off. Weatherford’s international revenue base is now closer to $4 billion annually, more than half the company’s total sales. Although Weatherford still sees startup costs, these costs are much smaller relative to that base. Weatherford has finally achieved critical mass in its international business.
Weatherford has also established a technological leadership position in some key service markets. Specifically, Weatherford’s controlled pressure drilling business (CPD) is a market leader.
Basically, hydrocarbons underground are under geological pressure. Oil and gas don’t exist underground in giant lakes or caverns but are located in the interconnected pores and crevices of rocks.
When a well is first drilled in a new field, those pressures can be immense. If you simply drilled the well, the hydrocarbons would move into the well under tremendous force and explode through the surface of the well, a situation known as a blowout.
Blowouts aren’t desirable for multiple reasons. First, it’s a waste of valuable oil and gas. In addition, it’s potentially dangerous if those hydrocarbons ignite and explode.
To prevent such blowouts, producers use what’s known as a circulating mud system. They pump a liquid substance known as drilling mud–often a fairly advanced mixture of chemicals–into the well under high pressure. This mud acts as a counterbalance to the hydrocarbons under extreme pressure.
But there’s a problem with this. Once a reservoir has been drilled, the pressure in the formation falls. If an operator decides to dig a new well into an existing mature field, it requires special attention.
If you pump mud under high pressure, it can actually enter the reservoir rock and clog the pores and crevices near the well; this can severely damage the well’s productivity. Therefore, the operator must carefully control the pressures while drilling.
In many cases, this involves underbalanced drilling. This occurs when the pressure of the mud is lower than the geologic pressure of the formation. This prevents damage to the reservoir but requires careful monitoring to prevent dangerous blowouts. Weatherford is a leader in this business.
Although underbalanced and controlled pressure drilling are Weatherford specialties, they’re certainly not the only product lines where Weatherford is on top. For example, the company has developed an expertise operating in high-temperature, high-pressure environments; this is common in deepwater reservoirs. And Weatherford also has strong product offerings in other key product lines such as solid expandables and rotary steerable systems (RSS).
To explain solid expandables, consider that when a well is drilled–particularly a deep well–the drill bit likely passes through several different geological layers. Some of these layers may be areas of unusually low or high pressures; alternatively the drill bit may pass through multiple deposits of water, oil and gas, each of differing pressures and temperatures.
To isolate certain zones that may cause trouble, operators install what’s known as casing, which is pipe cemented in place in the well. This insulates, for example, high-pressure zones so that fluid doesn’t flow into the well and cause problems.
The problem with this is that casing is thick, heavy gauge pipe. You may have to install several lengths of casing to isolate a given area of the well; there may also be multiple areas that need to be isolated.
Consider that each subsequent length of casing you lower into a well needs to be of slightly smaller diameter than the length before it in order for the casing to fit. Over time, the more lengths of casing you install, the thinner the diameter of the well. Therefore, when the well reaches its final depth, the well diameter may be smaller than optimum to produce efficiently. You can imagine how this could be an issue for a deeper well.
Weatherford’s solid expandables technology offers a solution to this problem. Basically, it’s a type of metal casing that can be placed in the well and expanded to fit the shape of the well itself.
This expandable will isolate trouble zones so that the operator can continue to drill the well without much loss of well diameter. Once the final intended depth of the well is attained, the operator can go back and case the individual segments.
This is just the sort of high-tech service function that’s in high demand right now, and Weatherford has a very real competitive advantage.
And RSS allows operators to literally steer the drill bit to target particular pockets of hydrocarbons. When targeting small fields, accuracy is important; proper well placement can mean the difference between an economic well and a useless dry hole. RSS systems are also in extraordinarily high demand.
At any rate, I see Weatherford’s international expansion strategy as uniquely sustainable in the current environment. Because the company isn’t overly dependent on offshore rigs for its growth, Weatherford should be able to survive the 2008 platform problem and what I suspect will be a temporary slowdown for the industry.
Once we start to see new floater rigs delivered and going into service, I’ll re-examine companies such as Schlumberger. For now, I think Weatherford’s superior growth prospects will spell major outperformance for the stock. In fact, that’s already happening; since the beginning of 2008, Weatherford is down just 6 percent against a 20 percent loss for Schlumberger and 13 percent for the Philadelphia Oil Services Index.
Despite that outperformance, Weatherford is still cheap, trading at around 15 times 2008 earnings estimates compared to nearly 16.5 times for Schlumberger, even after the latter’s recent slide. Weatherford International is now the only pure services name in the TES portfolios; the stock rates a buy under 72.
With that said, subscribers who bought the stock on my recommendation last spring are already up more than 30 percent. I’ve heard from many who fear that a further bout of general panic selling, such as we witnessed in January, would mean those gains evaporate quickly. After all, as I noted in the most recent issue of TES, all stocks do tend to head lower in tandem during broader market selloffs.
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Those with large profits in Weatherford should consider purchasing the May $60 put options (WFT QM) for around $400 per contract. Buy one put contract for every 100 shares of Weatherford you own. These options will serve to insure you against downside in the stock over the next few months.
Don’t purchase these options unless you already own Weatherford and have read and feel comfortable with the put protection strategy outlined in the “ABCs of Options to Hedge Risk” report. This recommendation is for hedging purposes only.
And take your remaining profits on my recommended Halliburton short position. I recommended shorting Halliburton in the Nov. 12, 2007, flash alert, Shorting Halliburton. I subsequently recommended taking half your profits (roughly 15 percent) off the table during the heart of the January selloff in the Jan. 18 flash alert, Cover Some Halliburton.
(For a basic primer on shorting, check out the June 14, 2006, issue of TES, The Good, The Bad, The Ugly. The relevant section is located near the end of that issue under the subheading “Pair Trades, Shorts and Puts.”)
My rationale for shorting Halliburton is simple: The company continues to have a great deal of exposure to the North American market. In particular, roughly a quarter of Halliburton’s profits come from North American pressure-pumping operations.
North American drilling activity is highly sensitive to natural gas prices. Unlike international projects, North American deals are short term and easily canceled or postponed; the weakness in natural gas prices has meant a very weak drilling environment in North America, particularly for Canada.
I described pressure pumping at length in the Nov. 7, 2007, issue of TES, Coal and Services. To summarize, pressure pumping is a service that’s absolutely necessary to produce gas from hot, new, unconventional reserves such as the Barnett Shale of Texas and the Rockies tight gas deposits.
The problem with this service line is that a number of companies have massively built up their capacity to perform pressure pumping in recent years. Therefore, not only has the drilling environment weakened, but the entire industry faces overcapacity problems. The result: pressure pumping in North America is by far the weakest major service function in the world right now.
Given Halliburton’s exposure to this market, I felt that shorts were a great way to play further downside in this market. And Halliburton has been an underperformer. However, I now recommend covering your remaining half position in Halliburton for a further gain of about 6 percent.
The reason is simply that Halliburton’s recent conference call was stronger than I expected, and the stock is now pricing in a great deal of bad news. Although the company admitted continued weakness in pressure pumping, it did highlight strength in some of its faster-growing international operations. Halliburton is facing the same platform issues as Schlumberger and Baker Hughes but still sees respectable 20 percent growth for international services this year.
And Halliburton is considerably cheaper than Schlumberger or Baker; the stock trades around 12 times 2008 earnings estimates compared to 16.5 for Schlumberger and 13 for Baker Hughes. Therefore, the stock may already be pricing in continued weakness for its lagging North American pressure pumping operations.
Although I recommend selling out of this short position, I haven’t changed my fundamental bearish position on Halliburton. I’ll continue to track it as a hold in the How They Rate Table.
Finally, it’s worth mentioning Compagnie Generale de Geophysique-Veritas (NYSE: CGV). I outlined my detailed rationale for owning this stock in the June 20, 2007, issue of TES, “Europe’s Gas.” To summarize, CGG performs seismic services both on land and for offshore fields. And CGG owns a fleet of 20 seismic vessels—the largest such fleet in the world.
Seismic services are used to explore for new oil and gas fields as well as to pinpoint and delineate existing formations. Basically, seismic operators use sound waves to develop a detailed picture of underground rock formations. Early seismic surveys were simple and prone to error, but over time, technology has advanced, and operators can now generate far more accurate, three-dimensional maps of formations. This is also true offshore.
It can cost well more than $1 million per day to drill a deepwater well. Operators want to make sure wells are placed as accurately as possible; drilling dry holes is an expensive proposition in the deepwater. Accurate seismic surveys are an absolute must.
The only problem is that there’s a major shortage of seismic ships globally, especially the most advanced ships used for surveying deepwater fields. CGG is one of the only providers in the world.
Schlumberger has a seismic division. Its fleet of “Q” seismic ships is among the most advanced in the world. This is one market where Schlumberger has seen absolutely no slowdown in growth or any knock-on effect from the platform problem.
In fact, Schlumberger recently acquired Eastern Echo, a seismic firm with six new, advanced seismic vessels on order. In its first quarter call, Schlumberger stated:
Clearly, seismic remains a strong business. In fact, producers may actually be accelerating their deepwater seismic activities. After all, although there are no deepwater rigs currently available, producers still need to identify drilling projects for the future. Therefore, they’re actually undertaking more seismic work in preparation for a time when more deepwater rigs are ready to drill.
With the seismic market still strong, CGG Veritas continues to look like an excellent play on this growth. Compagnie Generale de Geophysique-Veritas rates a buy under 55.
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However, floaters aren’t the only rigs scheduled for delivery over the next few years. The other major type of rig used internationally is what’s known as a jackup rig. The picture below of a jackup rig helps to visualize how these rigs work.
Source: Google
As you can see, jackup rigs are bottom-supported. There are actually several metal pilings that support the rig directly on the bottom of the sea.
Typically, jackup rigs are used for drilling in shallower waters, up to a few hundred feet in depth. But that’s not to say that all jackups are the same. Rough waters in the North Sea, for example, necessitate the use of rigs capable of handling harsh environments.
Other jackups are designed to drill deeper than others. Typically, more capable rigs are dubbed “high-spec” rigs, while simpler rigs are known as “commodity” jackups.
Just as with floaters there are a large number of jackup rigs scheduled to come out of shipyards over the next few years. The chart below offers a look at the newbuild schedule for jackup rigs.
Source: Offshore Magazine 2007 Worldwide MODU Construction/Upgrade Survey
There are a few points worth noting about jackups. First, they’re easier, cheaper and faster to build than advanced floaters. And second, the current jackup market isn’t as tight generally as the market for floaters, though there are certainly shortages of jackups in some key markets.
I’m confident that new floaters scheduled to be put into service over the next few years will have absolutely no trouble finding work. Producers are eagerly awaiting these rigs.
And remember that contract drillers don’t actually produce oil and gas but lease their rigs to operators for a daily fee known as a day-rate. Day-rates for ultra-deepwater rigs have been breaking out to new records in recent months. That’s the clearest sign of strong demand I can imagine.
I am, however, becoming less certain about the wave of new jackups scheduled to be built in coming years. Although the market for jackups is currently strong, I’m not as comfortable with the strength of this market as I am with the floater market.
Noble Corp is a contract driller with exposure to both the jackup and floater markets. As such, I found its conference call in late January an interesting insight into this market. Noble’s new CEO, David Williams, stated that he’d prefer to see Noble invest in expanding its deepwater floater fleet and not its jackup fleet.
The company reported that its advanced jackup fleet is already 75 percent contracted for 2008 and 33 percent booked for 2009, all at attractive rates. Management went on to say that contracts were still available in the North Sea for terms of about six months at attractive rates and elsewhere internationally for terms of as long as two years. This all sounds like a solid jackup market environment.
And management noted that it’s seen no widespread evidence that contractors are delaying or holding off on projects to wait for new jackups to come into service.
But management did point out that the value of high-specification jackups appears to be softening somewhat. The easiest way to determine this is to look at the share price of a handful of companies traded in Norway that own jackup rigs.
These aren’t operating companies, simply firms that have ordered and purchased new jackups; most are likely to try and sell those rigs before they’re delivered. One such firm is Petrojack (Oslo: JACK). Check out the chart below.
Source: Bloomberg
Petrojack owns two high-specification jackup rigs, one delivered in January and the second scheduled for delivery in December. Both rigs are capable of drilling in water up to 375 feet in depth and can drill to a total depth of 30,000 feet.
It’s clear from this chart that the stock has been sliding lately. Because its only asset is these rigs, the slide in Petrojack stock suggests its rigs are falling in value. The falling value of these jackups suggests that investors are looking for a softening in jackup day-rates.
My conclusion from all this is that day-rates for high-spec jackups are unlikely to fall off a cliff because new supply. However, I doubt that rates for such rigs will see much additional upside over the next few years.
As the market absorbs the new rig supply, operators are likely to be unwilling to pay up for jackup rigs. Rates should remain elevated but show little additional upside.
I currently recommend three offshore contract drillers in the TES portfolios: Pride International, Rowan Companies and Seadrill.
As I noted in the Jan. 2 issue, Seadrill owns a large fleet of ultra-deepwater rigs. Although Seadrill also owns a small fleet of jackups, it concentrates mainly on the highest-specification jackups capable of drilling in the most-complex environments. This is the jackup market I see as least vulnerable.
And Seadrill’s deepwater fleet is highly attractive. Unlike most of the company’s peer group, Seadrill didn’t contract the majority of its deepwater fleet under long-term deals several years ago; therefore, the company was able to take advantage of the strong market for deepwater rigs that’s prevailed over the past year and a half.
Meanwhile, many of its peers are still locked into long-term deals for their deepwater rigs at rates well under what the current supply constrained market would bear.
Seadrill has locked in some of the highest day-rates for its rigs of any firm in the business. And that’s despite the fact that many of its most valuable rigs are still under construction.
Even better, as of its most recent fleet status report, Seadrill has three advanced semisubmersible floaters and an ultra-deepwater drillship that have yet to be contracted. These four rigs are currently still under construction, but Seadrill is well placed to demand record day-rates for contracting these highly in-demand deepwater rigs.
Keep in mind that Seadrill’s contracts are long-term deals with large international producers. This represents essentially locked-in, guaranteed revenue with a high level of visibility.
As Seadrill’s rigs are delivered and put out on contracts over the next two years, the company will generate a veritable mound of cash. When that cash generative power becomes clear, I expect it to act as a catalyst for the stock.
Given Seadrill’s unique leverage to deepwater drilling, the stock still rates a buy under 25.50.
Rowan Companies has no exposure whatsoever to the deepwater market. Rather, the firm operates the most advanced dedicated fleet of jackups in the world today–a total of 21 rigs. Rowan also operates a less valuable fleet of 26 land drilling rigs in the US.
Rowan’s advanced fleet is in relatively high demand globally and is the least exposed to any moderation in growth for the jackup market. But given the early signs of softening in this market, Rowan looks to face at least some minor headwinds in coming months.
One potential catalyst for the stock would be the sale of its Le Tourneau division. Le Tourneau is a construction operation that builds and repairs drilling rigs both for Rowan and third-party customers. Rowan is the only contract driller to be significantly vertically integrated in this way, both building and operating rigs.
Most investors prefer pure-plays to conglomerate companies, and a large number of prominent investors are pushing for Rowan to sell Le Tourneau and become a pure-play contract driller.
Typically, manufacturing operations receive a higher earnings multiple than drillers; selling Le Tourneau, it’s argued, would unlock considerable value. Chief among the agitators is an activist investor, Steel Partners, which owns more than 9 percent of Rowan and is pushing for board seats.
Pending more news on a possible breakup, I continue to recommend holding on to Rowan Companies for now but I no longer recommend buying the stock if you don’t already own it.
I expect we’ll hear more news on management’s strategy and response to Steel Partners on its upcoming earnings release and conference call scheduled for the end of this month. If nothing emerges from that call, I may look to sell out of Rowan Companies.
For the record, the stock is currently showing a small 4 percent profit from my recommended price. Pending more news on a possible breakup, I’m cutting Rowan Companies to a hold for now, but I no longer recommend buying the stock if you don’t already own it.
My final offshore drilling play is Pride International, which owns a mixture of jackup rigs and floaters. In recent quarters, management has made clear its intention to concentrate more on the floater market, particularly the market for ultra-deepwater rigs.
As I explained at great length in the April 18, 2007, issue of TES, More Bullish Signs, Pride International is essentially a turnaround play. The company suffered under poor management for years and overhauled essentially its entire management team in 2005. Prior management took the company on a massive acquisition spree in the late 1990s, saddling Pride with a large debt burden and diversifying the company into a host of unrelated business lines.
New management has taken some steps to ameliorate Pride’s situation. The company finally sold off its underperforming Latin American land drilling business last year. Management has also used asset sales and improving cash flow–thanks to a strong drilling market–to pay down Pride’s debt burden to more reasonable levels.
And lately, Pride has actually taken steps to expand its deepwater exposure. The company has three ultra-deepwater units under construction, the first of which will be a drillship scheduled for delivery in the first quarter of 2010.
Pride announced a contract for that rig in late January worth about $480,000 per day. That’s a respectable day-rate, though certainly not at the high end of some of the contracts announced more recently. The deal offers a decent return on Pride’s $730 million purchase price for the drillship.
It’s likely this contract was actually negotiated some time ago, and Pride is only now announcing the deal. Deals for the remaining two drillships are likely to be signed at higher rates.
I also see potential for Pride to sell off its jackup operations at some point to become a pure play on the deepwater; such a move would enhance value. Many of Pride’s jackup rigs are commodity rigs that are more or less confined to the Gulf of Mexico (GoM).
The GoM jackup market has been one of the only real soft spots in the global drilling market in recent years. The reason is that GoM shallow-water drilling activity is dominated by smaller producers targeting gas.
Falling gas price is bad news for these producers and has prompted them to delay and cancel drilling projects. It’s the only area of real sustained weakness for jackup day-rates at this time.
But I do see signs of life for the GoM market. Ironically, this market is tightening up considerably. Day-rates available in the GoM are much lower than what’s available internationally.
Meanwhile, international operators are willing to offer multi-year contracts for jackups, while one-off drilling projects dominate activity in the GoM. Therefore, any operator with a jackup capable of working outside the GoM is booking a deal to move rigs out of the region.
The result: The supply of jackup rigs in the GoM has contracted notably over the past two years. Consider that there are currently only about 80 jackup rigs operating in the Gulf. About 11 of those are, in fact, work-over rigs that are used to effect well repairs, not actually drill new wells.
The real GoM rig supply is in the upper 60s. Consider that just a few years ago there were more than 150 jackups in the Gulf; the exodus of rigs has left the region unable to handle any upturn in business conditions.
In other words, with Gulf drilling activity now weak, there are enough rigs to handle business; in fact, some commodity jackups are sitting idle. However, if gas prices do stabilize and recover, a supply squeeze is imminent. And, as I explained in the most recent issue of TES, I expect some modest stabilization in gas prices and gas-related drilling activity this year.
The key company to watch when it comes to assessing the health of the GoM jackup market is Hercules Offshore (NSDQ: HERO). Hercules has the largest fleet of commodity rigs in the US GoM.
During its fourth quarter call last week, Hercules stated that the fourth quarter drilling market was very weak in the GoM. At one point, demand for jackup rigs fell to just 26, near record-low demand levels. For Hercules, its jackup fleet fell to a utilization level of 56 percent own from around 70 at the end of the third quarter.
Day-rates also took a tumble, falling from a range of about $55,000 to $65,000 at the end of the third quarter to about $50,000 to $60,000 today.
But all the news wasn’t bad out of the Hercules call. Management also stated that the pace of day-rate declined slowed to a crawl in the fourth quarter; in the third quarter, rates really cratered.
To combat the weak drilling environment and cut costs, Hercules also warm-stacked—placed into temporary storage—six of its rigs. Now Hercules believes at least some of those rigs will be going back to work this quarter.
Hercules also noted that its major customers are putting together their preliminary spending budgets for 2008; their interest in booking rigs is up about 7 percent. And most operators are basing their drilling plans on gas prices around $6.75 to $7.25 per million British thermal units (MMBtu). With gas prices currently closer to $8 per MMBtu, there’s room for budgets to actually expand in coming months.
Finally, it’s worth noting that Hercules reported that 2007 was a big year for deals in the GoM; producers were buying up acreage in the shallow-water Gulf. It’s only this year that these producers are starting to draw up drilling plans for their newly acquired territories.
Overall, these comments support a stabilization in the GoM jackup market. If there’s any more sustained uptick in demand, you can bet producers will quickly find a supply of less than 70 rigs to be totally inadequate for their needs.
Meanwhile, there’s essentially no chance any of the newbuild jackups I outlined above entering these markets. Most of the newbuilds are higher-spec rigs that can get much fatter day-rates outside GoM.
These comments bode well for the GoM jackup business. Ironically, I see the potential for a turnaround in this weakest corner of the jackup market, even if strength internationally moderates.
I generally like Pride’s plan to focus attention on the deepwater business. The new management team has also taken positive steps to clean up the mess left over by prior managers.
However, based on comments out of Pride in the past, I see little evidence it actually has plans to fully exit its jackup business in the near-term, though I suspect it could happen over the next few years. Without such a deal, there’s really no upside catalyst for Pride’s stock.
I’m therefore recommending that you sell Pride International. The stock is trading roughly in line with where I recommended it last spring. I will continue to track the stock as a hold in my How They Rate coverage universe.
I’m also suggesting you swap into Hercules Offshore as a purer play on a likely turnaround in the GoM drilling market this year. Hercules Offshore rates a buy under 26 with a stop at 18.25 in my growth-oriented Wildcatters Portfolio.
Finally, a bit of late-breaking news: Land drilling specialist Nabors Industries reported earnings after the bell Tuesday. Although I haven’t had enough time to fully delve into the conference call, my early read is that the report was solid, particularly for Nabors’ international business.
I highlighted this stock at more depth in the last issue of TES. Nabors Industries continues to rate a buy under 31.
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And it’s time: Vegas, baby! With Neil and Roger, I’ll head to the desert paradise May 12-15, 2008, for the Las Vegas Money Show at Mandalay Bay. Go to http://www.lasvegasmoneyshow.com or call 800-970-4355 to do the “what happens here stays here” thing.
Ultimately, the energy boom is driven by strong demand overseas and a continued tight supply environment. This bullish picture hasn’t changed. However, energy stocks are still stocks and are therefore not immune to broader market volatility.
But we can still make money in this environment. Some stocks, including a handful of names leveraged to a recovery in natural gas, should perform well. For the first time since early 2006, there are signs of stabilization in this market.
And not all energy-related firms are seeing the same trends. Careful stock selection has been the key to outperformance over the past few years, and that will likely remain the case in 2008.
In This Issue
In this issue, we’ll take a closer look at the oil services group, exploring why Weatherford International was the only name to show a truly solid performance. Weatherford is also the only name in the group I feel comfortable holding at this time; I see no slowdown in its booming international business.And we’ll also examine the offshore drilling business and why I believe it’s an excellent time to make a few plays on a turn in the Gulf of Mexico shallow-water drilling business.
Because the world’s large onshore fields are now mature, producers are increasingly targeting more complex fields in harsh environments such as the Arctic and deepwater. The complexity of these fields requires new tactics—and new deals. See Oil and Gas Services.
Although other oil and gas services may be experiencing some stalled growth, Weatherford International is still moving steadily, thanks to expansion into new markets. The company leads several high-demand sectors in technology and service. See Weathering the Storm.
I’ve recommended several put options in the past couple months, one of which is worth reviewing. There are also a couple oil service plays that I thought should be addressed. See Putting It to the Test.
I hold several contract drillers in the portfolios that serve as pure plays on this industry. Some will be stronger than others in the upcoming year. I review them here. See Contract Drillers.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
- Compangnie Generale de Geophysique-Veritas (Paris: GA; NYSE: CGV)
- Hercules Offshore (NSDQ: HERO)
- Nabors Industries (NYSE: NBR)
- Seadrill (Oslo: SDRL, OTC: SDRLF)
- Weatherford International (NYSE: WFT)
- Weatherford May $60 put options (WFT QM)
- Halliburton (NYSE: HAL)
- Pride International (NYSE: PDE)
- Rowan Companies (NYSE: RDC)
Oil and Gas Services
For the past three years, oil services stocks have been among the best performers in the energy patch. The Philadelphia Oil Services Index is up 100 percent, compared to just 82 percent for the S&P 500 Energy Index.And within the services sector, the key has been to focus your portfolio on services companies levered to growth offshore and outside of North America. International powerhouses Schlumberger and Weatherford International, for example, have outperformed the broader oil services index by roughly 30 percent over the past three years.
The main reason for this growth relates back to one of the core themes of this newsletter: the end of easy oil. (I highlighted this theme and what it means for the services group at length in the Jan. 2 issue of TES, Taking Stock of 2007.)
Because the world’s large onshore fields are now mature, producers are increasingly targeting more complex fields in harsh environments such as the Arctic and deepwater. Onshore, producers are going after smaller pockets of oil; to produce these fields requires the use of the most-advanced well designs and oilfield technologies. These trends all play right into the hands of the world’s oil services firms.
Another factor aiding the services firms is petro-nationalism. Traditionally, the state-owned or partly state-owned national oil companies (NOC) have preferred to partner with major integrated oil firms on exploration and development projects. The majors, including companies such as Total, ExxonMobil and Chevron Corp, have the experience, technology and project management skills required to handle complex projects.
In exchange for providing these services, the NOC would typically offer the integrated majors a share in the production of their projects. In many cases, the NOCs were even willing to cede overall control of key projects to the majors.
That’s no longer the case. In recent years, NOCs and foreign governments have started to exert more influence over major oil projects; in some cases, this has involved actually changing the terms of partnership deals with the integrated majors.
For example, Kazakhstan recently renegotiated the terms of its partnership with foreign integrated oil companies to develop the giant Kashagan field in the Caspian Sea. The consortium of foreign oil giants developing the field–including Eni, ExxonMobil and Royal Dutch Shell–agreed to pay Kazakhstan $2.5 billion to $4.5 billion in compensation for the late start of the project. In addition, Kazakhstan’s NOC is doubling its stake in the deal.
We’re also seeing the big NOCs partner with major oil services firms such as Schlumberger on development deals rather than oil majors. Rather than partner with an integrated firm and be forced to give up a stake in the field, the NOCs simply pay the services firms to manage the project on their behalf. This business line is known as integrated project management (IPM).
The NOC will normally contract with a services firm to manage all aspects of a project. That may include arranging drilling rigs, ordering equipment or contracting with other services firms for certain aspects of the job.
The key point is that the NOCs can get access to the most advanced oilfield technologies without having to give up a share or cede control in their fields to a major foreign oil company. IPM is one of the hottest, fastest-growing business lines for the major service firms. Petro-nationalism is another key growth driver.
This basic bullish case for the services firms remains intact longer term. However, based on recent results and conference calls, I think the bull case for the services firms is on hold for the next quarter or so, thanks to what’s come to be known as the platform problem. Although stocks such as Schlumberger are well supported on a valuation basis, I just don’t see a great deal of near-term upside.
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Weathering the Storm
The only exception is longstanding Wildcatters Portfolio member Weatherford International. Weatherford was the only firm among the international services names to react well to its fourth quarter earnings report. Weatherford’s international growth story appears to be intact, and I see a real, differentiated case for owning the stock while avoiding the other international names for now.I mentioned the platform problem in the most recent issue of TES with reference to Schlumberger. The basic problem is that demand for offshore oil and gas exploration and development remains strong, but there just aren’t enough drilling rigs out there to handle all of the projects. Producers would like to drill more aggressively but can’t get access to the rigs.
To make matters worse, when a new drilling rig is first launched, it takes time for that rig to reach peak efficiency; brand new rigs aren’t as efficient as rigs that have been in service for a few years. Therefore, services firms such as Schlumberger have stated that they see their international growth constrained by the lack of rig platforms available to pursue projects.
This isn’t a new phenomenon. As I highlighted in the most recent issue of TES, Schlumberger offered an early warning of the platform problem in its third quarter conference call last year. However, it does appear that the problem is more acute than many had assumed.
This is clear from Baker Hughes‘ earnings report released last week. Baker stated that deepwater activity will remain constrained this year because of lack of rig availability.
The company also noted that some of its highest-margin services are those that pertain to deepwater work. The platform problem will have an outsized effect on profitability by hitting hardest Baker’s most profitable service lines. The company went on to describe 2008 as a transitional year for the services industry because of this issue.
Another worrying trend to emerge from Baker’s call was the idea of heightened competition among the big services firms for high-profile projects. Baker’s CEO Chad Deaton stated that he’s starting to see some aggressiveness on the big contracts out there.
The major oil services firms are competing for these deals partly on price. Deaton was careful to say that pricing power is holding up well internationally.
But this raises the possibility that, because of the platform issue, services firms are having trouble finding growth offshore. That means they’re competing aggressively on a handful of big international deals. If that’s the case, it could mean there’s more pricing pressure to come on the international front.
I suspect we’ll see this platform issue gradually fade after midyear. The reason is simply that a host of new offshore rigs are finally coming out of shipyards and going into service. Check out the chart below for a closer look.
Source: Offshore Magazine 2007 Worldwide MODU Construction/Upgrade Survey
The chart shows scheduled deliveries of newbuild floater rigs over the next few years. Floater rigs are literally rigs that are designed to float on the water rather than be supported by pilings that touch the bottom of the sea. They’re typically used for drilling in deeper waters.
To construct the chart, I included both newly built rigs and those undergoing major renovations. I further divided each bar in the chart between total floaters scheduled for delivery and ultra-deepwater rigs. The ultra-deepwater rigs are rigs capable of drilling in water of more than 7,500 feet in depth. These would represent the most advanced deepwater rigs.
It’s clear from the charts that, during the next year, a wave of newbuild floater rigs are scheduled for delivery. Many of these rigs are capable of drilling in the deepest waters.
The essence of the platform problem is that there aren’t enough deepwater rigs to meet demand; as these rigs are delivered, that problem will gradually ease. But this process will take time.
Based on what I’m hearing from companies like Schlumberger and Baker Hughes, I’m looking for the services firms to enter a soft patch over the next six months or so. These companies will see their international growth constrained by lack of rig availability (the platform problem), while the few big contracts that do come up will be aggressively bid.
That means there’s risk they could be forced to cut prices to win business. This certainly won’t destroy growth prospects, but it will be enough to temper their pricing power and near-term growth prospects.
This brings me to Weatherford. I must confess a degree of incredulity arising from my initial consideration of the company’s results and management’s conference call; Weatherford, Schlumberger and Baker Hughes are all in the same basic business and have the same overall customer base.
It would seem ridiculous to believe that Weatherford could somehow thrive while all its competitors are trying to talk down analysts’ earnings estimates and warning about platform issues. Yet Weatherford says it’s looking for growth rates of close to 40 percent over the next two years in its international markets, while Schlumberger is looking for growth at basically half that level.
Apparently, I wasn’t the only one who had that thought. Weatherford’s management team was grilled during the question-and-answer session following the conference call by several analysts from different firms. The basic question: “How can Weatherford’s international growth remain so strong while competitors are struggling with the platform problem?”
A couple logical reasons for Weatherford’s outperformance emerged from this discussion. First and foremost, Weatherford is starting from a much smaller base on many of its key product lines. The company has some highly competitive, relatively new technologies that aren’t yet widely marketed and deployed in all oil- and gas-producing countries of the world.
As Weatherford rolls out these high-tech services into new international markets, it’s able to generate growth quickly. In other words, there are still plenty of markets where Weatherford doesn’t yet have a major presence. As the company targets these new markets, it’s able to grow far faster than the industry average.
In response to an analyst query, the company’s CFO Andrew Becnel stated:
Think about some of these younger product lines where we might have operations in 10, 20, maybe 30 of the 100 countries we are in today. And so seeding these opportunities in new countries in a very focused way–not getting too distracted and trying to do too many things–makes a big difference. And what’s an accelerator of that growth is putting more scale on operations we seeded in late 2005, 2006 and this year. And those are going to benefit your growth in 2008 and 2009.
Weatherford has room to grow by simply taking proven, existing technologies and selling them into new markets. This differs from a company such as Schlumberger, which has already saturated many of its key markets and, therefore, has less room to expand from the same process.
A perfect example is Russia, a market where Weatherford had almost no exposure just a few years ago. (I highlighted the attractiveness of the Russian market at length in the Dec. 19, 2007, issue of TES, Focus on Russia.) Weatherford aggressively targeted this market to boost its presence.
Although the company did make a few small acquisitions, most of the growth was organic; Weatherford simply sold its existing services into this new market. Now the company has more than 2,500 employees in Russia.
I also see Weatherford entering the sweet spot of its growth cycle right now. Consider that just three years ago, Weatherford had far greater exposure to the North American market; its international operations were still relatively small.
As Weatherford began to expand internationally, it hired new employees in global markets and spent considerable sums building its presence. With the base of international revenues still small, these startup costs were high relative to international revenues.
But that investment is beginning to pay off. Weatherford’s international revenue base is now closer to $4 billion annually, more than half the company’s total sales. Although Weatherford still sees startup costs, these costs are much smaller relative to that base. Weatherford has finally achieved critical mass in its international business.
Weatherford has also established a technological leadership position in some key service markets. Specifically, Weatherford’s controlled pressure drilling business (CPD) is a market leader.
Basically, hydrocarbons underground are under geological pressure. Oil and gas don’t exist underground in giant lakes or caverns but are located in the interconnected pores and crevices of rocks.
When a well is first drilled in a new field, those pressures can be immense. If you simply drilled the well, the hydrocarbons would move into the well under tremendous force and explode through the surface of the well, a situation known as a blowout.
Blowouts aren’t desirable for multiple reasons. First, it’s a waste of valuable oil and gas. In addition, it’s potentially dangerous if those hydrocarbons ignite and explode.
To prevent such blowouts, producers use what’s known as a circulating mud system. They pump a liquid substance known as drilling mud–often a fairly advanced mixture of chemicals–into the well under high pressure. This mud acts as a counterbalance to the hydrocarbons under extreme pressure.
But there’s a problem with this. Once a reservoir has been drilled, the pressure in the formation falls. If an operator decides to dig a new well into an existing mature field, it requires special attention.
If you pump mud under high pressure, it can actually enter the reservoir rock and clog the pores and crevices near the well; this can severely damage the well’s productivity. Therefore, the operator must carefully control the pressures while drilling.
In many cases, this involves underbalanced drilling. This occurs when the pressure of the mud is lower than the geologic pressure of the formation. This prevents damage to the reservoir but requires careful monitoring to prevent dangerous blowouts. Weatherford is a leader in this business.
Although underbalanced and controlled pressure drilling are Weatherford specialties, they’re certainly not the only product lines where Weatherford is on top. For example, the company has developed an expertise operating in high-temperature, high-pressure environments; this is common in deepwater reservoirs. And Weatherford also has strong product offerings in other key product lines such as solid expandables and rotary steerable systems (RSS).
To explain solid expandables, consider that when a well is drilled–particularly a deep well–the drill bit likely passes through several different geological layers. Some of these layers may be areas of unusually low or high pressures; alternatively the drill bit may pass through multiple deposits of water, oil and gas, each of differing pressures and temperatures.
To isolate certain zones that may cause trouble, operators install what’s known as casing, which is pipe cemented in place in the well. This insulates, for example, high-pressure zones so that fluid doesn’t flow into the well and cause problems.
The problem with this is that casing is thick, heavy gauge pipe. You may have to install several lengths of casing to isolate a given area of the well; there may also be multiple areas that need to be isolated.
Consider that each subsequent length of casing you lower into a well needs to be of slightly smaller diameter than the length before it in order for the casing to fit. Over time, the more lengths of casing you install, the thinner the diameter of the well. Therefore, when the well reaches its final depth, the well diameter may be smaller than optimum to produce efficiently. You can imagine how this could be an issue for a deeper well.
Weatherford’s solid expandables technology offers a solution to this problem. Basically, it’s a type of metal casing that can be placed in the well and expanded to fit the shape of the well itself.
This expandable will isolate trouble zones so that the operator can continue to drill the well without much loss of well diameter. Once the final intended depth of the well is attained, the operator can go back and case the individual segments.
This is just the sort of high-tech service function that’s in high demand right now, and Weatherford has a very real competitive advantage.
And RSS allows operators to literally steer the drill bit to target particular pockets of hydrocarbons. When targeting small fields, accuracy is important; proper well placement can mean the difference between an economic well and a useless dry hole. RSS systems are also in extraordinarily high demand.
At any rate, I see Weatherford’s international expansion strategy as uniquely sustainable in the current environment. Because the company isn’t overly dependent on offshore rigs for its growth, Weatherford should be able to survive the 2008 platform problem and what I suspect will be a temporary slowdown for the industry.
Once we start to see new floater rigs delivered and going into service, I’ll re-examine companies such as Schlumberger. For now, I think Weatherford’s superior growth prospects will spell major outperformance for the stock. In fact, that’s already happening; since the beginning of 2008, Weatherford is down just 6 percent against a 20 percent loss for Schlumberger and 13 percent for the Philadelphia Oil Services Index.
Despite that outperformance, Weatherford is still cheap, trading at around 15 times 2008 earnings estimates compared to nearly 16.5 times for Schlumberger, even after the latter’s recent slide. Weatherford International is now the only pure services name in the TES portfolios; the stock rates a buy under 72.
With that said, subscribers who bought the stock on my recommendation last spring are already up more than 30 percent. I’ve heard from many who fear that a further bout of general panic selling, such as we witnessed in January, would mean those gains evaporate quickly. After all, as I noted in the most recent issue of TES, all stocks do tend to head lower in tandem during broader market selloffs.
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Put It to the Test
If you’re looking to protect your gains without sacrificing upside potential, please check out the free special report The ABCs of Options to Hedge Risk. One of the strategies I explain in the report is protective put buying.Those with large profits in Weatherford should consider purchasing the May $60 put options (WFT QM) for around $400 per contract. Buy one put contract for every 100 shares of Weatherford you own. These options will serve to insure you against downside in the stock over the next few months.
Don’t purchase these options unless you already own Weatherford and have read and feel comfortable with the put protection strategy outlined in the “ABCs of Options to Hedge Risk” report. This recommendation is for hedging purposes only.
And take your remaining profits on my recommended Halliburton short position. I recommended shorting Halliburton in the Nov. 12, 2007, flash alert, Shorting Halliburton. I subsequently recommended taking half your profits (roughly 15 percent) off the table during the heart of the January selloff in the Jan. 18 flash alert, Cover Some Halliburton.
(For a basic primer on shorting, check out the June 14, 2006, issue of TES, The Good, The Bad, The Ugly. The relevant section is located near the end of that issue under the subheading “Pair Trades, Shorts and Puts.”)
My rationale for shorting Halliburton is simple: The company continues to have a great deal of exposure to the North American market. In particular, roughly a quarter of Halliburton’s profits come from North American pressure-pumping operations.
North American drilling activity is highly sensitive to natural gas prices. Unlike international projects, North American deals are short term and easily canceled or postponed; the weakness in natural gas prices has meant a very weak drilling environment in North America, particularly for Canada.
I described pressure pumping at length in the Nov. 7, 2007, issue of TES, Coal and Services. To summarize, pressure pumping is a service that’s absolutely necessary to produce gas from hot, new, unconventional reserves such as the Barnett Shale of Texas and the Rockies tight gas deposits.
The problem with this service line is that a number of companies have massively built up their capacity to perform pressure pumping in recent years. Therefore, not only has the drilling environment weakened, but the entire industry faces overcapacity problems. The result: pressure pumping in North America is by far the weakest major service function in the world right now.
Given Halliburton’s exposure to this market, I felt that shorts were a great way to play further downside in this market. And Halliburton has been an underperformer. However, I now recommend covering your remaining half position in Halliburton for a further gain of about 6 percent.
The reason is simply that Halliburton’s recent conference call was stronger than I expected, and the stock is now pricing in a great deal of bad news. Although the company admitted continued weakness in pressure pumping, it did highlight strength in some of its faster-growing international operations. Halliburton is facing the same platform issues as Schlumberger and Baker Hughes but still sees respectable 20 percent growth for international services this year.
And Halliburton is considerably cheaper than Schlumberger or Baker; the stock trades around 12 times 2008 earnings estimates compared to 16.5 for Schlumberger and 13 for Baker Hughes. Therefore, the stock may already be pricing in continued weakness for its lagging North American pressure pumping operations.
Although I recommend selling out of this short position, I haven’t changed my fundamental bearish position on Halliburton. I’ll continue to track it as a hold in the How They Rate Table.
Finally, it’s worth mentioning Compagnie Generale de Geophysique-Veritas (NYSE: CGV). I outlined my detailed rationale for owning this stock in the June 20, 2007, issue of TES, “Europe’s Gas.” To summarize, CGG performs seismic services both on land and for offshore fields. And CGG owns a fleet of 20 seismic vessels—the largest such fleet in the world.
Seismic services are used to explore for new oil and gas fields as well as to pinpoint and delineate existing formations. Basically, seismic operators use sound waves to develop a detailed picture of underground rock formations. Early seismic surveys were simple and prone to error, but over time, technology has advanced, and operators can now generate far more accurate, three-dimensional maps of formations. This is also true offshore.
It can cost well more than $1 million per day to drill a deepwater well. Operators want to make sure wells are placed as accurately as possible; drilling dry holes is an expensive proposition in the deepwater. Accurate seismic surveys are an absolute must.
The only problem is that there’s a major shortage of seismic ships globally, especially the most advanced ships used for surveying deepwater fields. CGG is one of the only providers in the world.
Schlumberger has a seismic division. Its fleet of “Q” seismic ships is among the most advanced in the world. This is one market where Schlumberger has seen absolutely no slowdown in growth or any knock-on effect from the platform problem.
In fact, Schlumberger recently acquired Eastern Echo, a seismic firm with six new, advanced seismic vessels on order. In its first quarter call, Schlumberger stated:
The strength of the seismic market, particularly in marine, led us to review our long-term plans for the fleet, and this led to our acquisition of Eastern Echo during the quarter. The six high-performance vessels on order offer high capacity and are ideally suited to the exploration and development markets of the future…
Clearly, seismic remains a strong business. In fact, producers may actually be accelerating their deepwater seismic activities. After all, although there are no deepwater rigs currently available, producers still need to identify drilling projects for the future. Therefore, they’re actually undertaking more seismic work in preparation for a time when more deepwater rigs are ready to drill.
With the seismic market still strong, CGG Veritas continues to look like an excellent play on this growth. Compagnie Generale de Geophysique-Veritas rates a buy under 55.
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Contract Drillers
In discussing the platform problem above, I noted that there are a large number of floater rigs scheduled for delivery over the next few years. Currently, services firms are hitting a wall when it comes to growth because of a lack of available rigs to perform deepwater work. Gradually, as rigs are delivered, this situation will improve.However, floaters aren’t the only rigs scheduled for delivery over the next few years. The other major type of rig used internationally is what’s known as a jackup rig. The picture below of a jackup rig helps to visualize how these rigs work.
Source: Google
As you can see, jackup rigs are bottom-supported. There are actually several metal pilings that support the rig directly on the bottom of the sea.
Typically, jackup rigs are used for drilling in shallower waters, up to a few hundred feet in depth. But that’s not to say that all jackups are the same. Rough waters in the North Sea, for example, necessitate the use of rigs capable of handling harsh environments.
Other jackups are designed to drill deeper than others. Typically, more capable rigs are dubbed “high-spec” rigs, while simpler rigs are known as “commodity” jackups.
Just as with floaters there are a large number of jackup rigs scheduled to come out of shipyards over the next few years. The chart below offers a look at the newbuild schedule for jackup rigs.
Source: Offshore Magazine 2007 Worldwide MODU Construction/Upgrade Survey
There are a few points worth noting about jackups. First, they’re easier, cheaper and faster to build than advanced floaters. And second, the current jackup market isn’t as tight generally as the market for floaters, though there are certainly shortages of jackups in some key markets.
I’m confident that new floaters scheduled to be put into service over the next few years will have absolutely no trouble finding work. Producers are eagerly awaiting these rigs.
And remember that contract drillers don’t actually produce oil and gas but lease their rigs to operators for a daily fee known as a day-rate. Day-rates for ultra-deepwater rigs have been breaking out to new records in recent months. That’s the clearest sign of strong demand I can imagine.
I am, however, becoming less certain about the wave of new jackups scheduled to be built in coming years. Although the market for jackups is currently strong, I’m not as comfortable with the strength of this market as I am with the floater market.
Noble Corp is a contract driller with exposure to both the jackup and floater markets. As such, I found its conference call in late January an interesting insight into this market. Noble’s new CEO, David Williams, stated that he’d prefer to see Noble invest in expanding its deepwater floater fleet and not its jackup fleet.
The company reported that its advanced jackup fleet is already 75 percent contracted for 2008 and 33 percent booked for 2009, all at attractive rates. Management went on to say that contracts were still available in the North Sea for terms of about six months at attractive rates and elsewhere internationally for terms of as long as two years. This all sounds like a solid jackup market environment.
And management noted that it’s seen no widespread evidence that contractors are delaying or holding off on projects to wait for new jackups to come into service.
But management did point out that the value of high-specification jackups appears to be softening somewhat. The easiest way to determine this is to look at the share price of a handful of companies traded in Norway that own jackup rigs.
These aren’t operating companies, simply firms that have ordered and purchased new jackups; most are likely to try and sell those rigs before they’re delivered. One such firm is Petrojack (Oslo: JACK). Check out the chart below.
Source: Bloomberg
Petrojack owns two high-specification jackup rigs, one delivered in January and the second scheduled for delivery in December. Both rigs are capable of drilling in water up to 375 feet in depth and can drill to a total depth of 30,000 feet.
It’s clear from this chart that the stock has been sliding lately. Because its only asset is these rigs, the slide in Petrojack stock suggests its rigs are falling in value. The falling value of these jackups suggests that investors are looking for a softening in jackup day-rates.
My conclusion from all this is that day-rates for high-spec jackups are unlikely to fall off a cliff because new supply. However, I doubt that rates for such rigs will see much additional upside over the next few years.
As the market absorbs the new rig supply, operators are likely to be unwilling to pay up for jackup rigs. Rates should remain elevated but show little additional upside.
I currently recommend three offshore contract drillers in the TES portfolios: Pride International, Rowan Companies and Seadrill.
As I noted in the Jan. 2 issue, Seadrill owns a large fleet of ultra-deepwater rigs. Although Seadrill also owns a small fleet of jackups, it concentrates mainly on the highest-specification jackups capable of drilling in the most-complex environments. This is the jackup market I see as least vulnerable.
And Seadrill’s deepwater fleet is highly attractive. Unlike most of the company’s peer group, Seadrill didn’t contract the majority of its deepwater fleet under long-term deals several years ago; therefore, the company was able to take advantage of the strong market for deepwater rigs that’s prevailed over the past year and a half.
Meanwhile, many of its peers are still locked into long-term deals for their deepwater rigs at rates well under what the current supply constrained market would bear.
Seadrill has locked in some of the highest day-rates for its rigs of any firm in the business. And that’s despite the fact that many of its most valuable rigs are still under construction.
Even better, as of its most recent fleet status report, Seadrill has three advanced semisubmersible floaters and an ultra-deepwater drillship that have yet to be contracted. These four rigs are currently still under construction, but Seadrill is well placed to demand record day-rates for contracting these highly in-demand deepwater rigs.
Keep in mind that Seadrill’s contracts are long-term deals with large international producers. This represents essentially locked-in, guaranteed revenue with a high level of visibility.
As Seadrill’s rigs are delivered and put out on contracts over the next two years, the company will generate a veritable mound of cash. When that cash generative power becomes clear, I expect it to act as a catalyst for the stock.
Given Seadrill’s unique leverage to deepwater drilling, the stock still rates a buy under 25.50.
Rowan Companies has no exposure whatsoever to the deepwater market. Rather, the firm operates the most advanced dedicated fleet of jackups in the world today–a total of 21 rigs. Rowan also operates a less valuable fleet of 26 land drilling rigs in the US.
Rowan’s advanced fleet is in relatively high demand globally and is the least exposed to any moderation in growth for the jackup market. But given the early signs of softening in this market, Rowan looks to face at least some minor headwinds in coming months.
One potential catalyst for the stock would be the sale of its Le Tourneau division. Le Tourneau is a construction operation that builds and repairs drilling rigs both for Rowan and third-party customers. Rowan is the only contract driller to be significantly vertically integrated in this way, both building and operating rigs.
Most investors prefer pure-plays to conglomerate companies, and a large number of prominent investors are pushing for Rowan to sell Le Tourneau and become a pure-play contract driller.
Typically, manufacturing operations receive a higher earnings multiple than drillers; selling Le Tourneau, it’s argued, would unlock considerable value. Chief among the agitators is an activist investor, Steel Partners, which owns more than 9 percent of Rowan and is pushing for board seats.
Pending more news on a possible breakup, I continue to recommend holding on to Rowan Companies for now but I no longer recommend buying the stock if you don’t already own it.
I expect we’ll hear more news on management’s strategy and response to Steel Partners on its upcoming earnings release and conference call scheduled for the end of this month. If nothing emerges from that call, I may look to sell out of Rowan Companies.
For the record, the stock is currently showing a small 4 percent profit from my recommended price. Pending more news on a possible breakup, I’m cutting Rowan Companies to a hold for now, but I no longer recommend buying the stock if you don’t already own it.
My final offshore drilling play is Pride International, which owns a mixture of jackup rigs and floaters. In recent quarters, management has made clear its intention to concentrate more on the floater market, particularly the market for ultra-deepwater rigs.
As I explained at great length in the April 18, 2007, issue of TES, More Bullish Signs, Pride International is essentially a turnaround play. The company suffered under poor management for years and overhauled essentially its entire management team in 2005. Prior management took the company on a massive acquisition spree in the late 1990s, saddling Pride with a large debt burden and diversifying the company into a host of unrelated business lines.
New management has taken some steps to ameliorate Pride’s situation. The company finally sold off its underperforming Latin American land drilling business last year. Management has also used asset sales and improving cash flow–thanks to a strong drilling market–to pay down Pride’s debt burden to more reasonable levels.
And lately, Pride has actually taken steps to expand its deepwater exposure. The company has three ultra-deepwater units under construction, the first of which will be a drillship scheduled for delivery in the first quarter of 2010.
Pride announced a contract for that rig in late January worth about $480,000 per day. That’s a respectable day-rate, though certainly not at the high end of some of the contracts announced more recently. The deal offers a decent return on Pride’s $730 million purchase price for the drillship.
It’s likely this contract was actually negotiated some time ago, and Pride is only now announcing the deal. Deals for the remaining two drillships are likely to be signed at higher rates.
I also see potential for Pride to sell off its jackup operations at some point to become a pure play on the deepwater; such a move would enhance value. Many of Pride’s jackup rigs are commodity rigs that are more or less confined to the Gulf of Mexico (GoM).
The GoM jackup market has been one of the only real soft spots in the global drilling market in recent years. The reason is that GoM shallow-water drilling activity is dominated by smaller producers targeting gas.
Falling gas price is bad news for these producers and has prompted them to delay and cancel drilling projects. It’s the only area of real sustained weakness for jackup day-rates at this time.
But I do see signs of life for the GoM market. Ironically, this market is tightening up considerably. Day-rates available in the GoM are much lower than what’s available internationally.
Meanwhile, international operators are willing to offer multi-year contracts for jackups, while one-off drilling projects dominate activity in the GoM. Therefore, any operator with a jackup capable of working outside the GoM is booking a deal to move rigs out of the region.
The result: The supply of jackup rigs in the GoM has contracted notably over the past two years. Consider that there are currently only about 80 jackup rigs operating in the Gulf. About 11 of those are, in fact, work-over rigs that are used to effect well repairs, not actually drill new wells.
The real GoM rig supply is in the upper 60s. Consider that just a few years ago there were more than 150 jackups in the Gulf; the exodus of rigs has left the region unable to handle any upturn in business conditions.
In other words, with Gulf drilling activity now weak, there are enough rigs to handle business; in fact, some commodity jackups are sitting idle. However, if gas prices do stabilize and recover, a supply squeeze is imminent. And, as I explained in the most recent issue of TES, I expect some modest stabilization in gas prices and gas-related drilling activity this year.
The key company to watch when it comes to assessing the health of the GoM jackup market is Hercules Offshore (NSDQ: HERO). Hercules has the largest fleet of commodity rigs in the US GoM.
During its fourth quarter call last week, Hercules stated that the fourth quarter drilling market was very weak in the GoM. At one point, demand for jackup rigs fell to just 26, near record-low demand levels. For Hercules, its jackup fleet fell to a utilization level of 56 percent own from around 70 at the end of the third quarter.
Day-rates also took a tumble, falling from a range of about $55,000 to $65,000 at the end of the third quarter to about $50,000 to $60,000 today.
But all the news wasn’t bad out of the Hercules call. Management also stated that the pace of day-rate declined slowed to a crawl in the fourth quarter; in the third quarter, rates really cratered.
To combat the weak drilling environment and cut costs, Hercules also warm-stacked—placed into temporary storage—six of its rigs. Now Hercules believes at least some of those rigs will be going back to work this quarter.
Hercules also noted that its major customers are putting together their preliminary spending budgets for 2008; their interest in booking rigs is up about 7 percent. And most operators are basing their drilling plans on gas prices around $6.75 to $7.25 per million British thermal units (MMBtu). With gas prices currently closer to $8 per MMBtu, there’s room for budgets to actually expand in coming months.
Finally, it’s worth noting that Hercules reported that 2007 was a big year for deals in the GoM; producers were buying up acreage in the shallow-water Gulf. It’s only this year that these producers are starting to draw up drilling plans for their newly acquired territories.
Overall, these comments support a stabilization in the GoM jackup market. If there’s any more sustained uptick in demand, you can bet producers will quickly find a supply of less than 70 rigs to be totally inadequate for their needs.
Meanwhile, there’s essentially no chance any of the newbuild jackups I outlined above entering these markets. Most of the newbuilds are higher-spec rigs that can get much fatter day-rates outside GoM.
These comments bode well for the GoM jackup business. Ironically, I see the potential for a turnaround in this weakest corner of the jackup market, even if strength internationally moderates.
I generally like Pride’s plan to focus attention on the deepwater business. The new management team has also taken positive steps to clean up the mess left over by prior managers.
However, based on comments out of Pride in the past, I see little evidence it actually has plans to fully exit its jackup business in the near-term, though I suspect it could happen over the next few years. Without such a deal, there’s really no upside catalyst for Pride’s stock.
I’m therefore recommending that you sell Pride International. The stock is trading roughly in line with where I recommended it last spring. I will continue to track the stock as a hold in my How They Rate coverage universe.
I’m also suggesting you swap into Hercules Offshore as a purer play on a likely turnaround in the GoM drilling market this year. Hercules Offshore rates a buy under 26 with a stop at 18.25 in my growth-oriented Wildcatters Portfolio.
Finally, a bit of late-breaking news: Land drilling specialist Nabors Industries reported earnings after the bell Tuesday. Although I haven’t had enough time to fully delve into the conference call, my early read is that the report was solid, particularly for Nabors’ international business.
I highlighted this stock at more depth in the last issue of TES. Nabors Industries continues to rate a buy under 31.
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